Lecture Objectives

1. Lecture Objectives • leading theories to explain each type of investment • why investment is negatively related to the discount rate • Factors that shift the investment function • why investment rises during booms and falls during recessions • What are the criteria for investment decisions

2. Total investment Business fixed investment Residential investment Change in inventories U.S. Investment and its components, 1970-2009 Billions of 2005 dollars

3. Definitions • Present and Future Value • = (1+n) = • = (1+n)=(1+n) (1+n)= • = • = =

4. Investment Criteria • Net Present Value (NPV)≥ 0 • NPV = -F + + + … + • Benefit Cost Ratio ≥ 1 = • Internal rate of Return≥ Discount Rate • F = + + … + r ≥ n

5. Equilibrium Investment Ranking Investment Projects in Order of Their (NPV)/ (F) I I’ I*

6. Understanding business fixed investment • The standard model of business fixed investment: the neoclassical model of investment • Shows how investment depends on: • MP(K) • Discount rate • Tax rules affecting firms

7. Two types of firms In this context, “investment” is the rental firms’ spending on new capital goods. • For simplicity, assume two types of firms: 1. Production firms rent the capital they use to produce goods and services. 2. Rental firms own capital, rent it to production firms.

8. real rental price, R/P capital supply The capital rental market equilibrium rental rate capital demand (MPK) K capital stock Production firms must decide how much capital to rent. Competitive firms rent capital to the point where MPK = R/P.

9. Rental firms’ investment decisions Rental firms invest in new capital when the benefit of doing so exceeds the cost. The benefit (per unit capital): R/P, the income that rental firms earn from renting the unit of capital to production firms.

10. The (user) cost of capital Depreciation cost + Opportunity cost – Capital gain + Maintenance cost At equil. Cost of Capital = Rental Price of Capital

11. Then, opportunity cost = depreciation cost = capital loss(gain) = total cost = The cost of capital Nominal cost of capital Example: car rental company (capital: cars) Suppose PK = $10,000, i = 0.10, and ∆PK/PK = 0.06 ᵟ = 0.20 $1000 $2000 - $600 $2400

12. Net investment & gross investment Hence, where In[ ] is a function that shows how net investment responds to the incentive to invest. Total spending on business fixed investment equals net investment plus replacement of depreciated K:

13. r r1 The investment function I1 I An increase in r: • raises the cost of capital • reduces the profit rate • and reduces investment: r2 I2

14. r r1 The investment function I2 I1 I An increase in MPKor decrease in PK/P • increases the profit rate • increases investment at any given discount rate • shifts I curve to the right.

15. Sources of Investment Financing r, n Investment Demand Supply of fund Musharaka Financing O I I*

16. The Accelerator Theory of Investment The Fixed Accelerator The Flexible Accelerator I = - ) ˂ 1 I = K ˂ Investment is More Stable • = • > 1 • I = - = K • = = • I = - = • Small Change in Q has Accelerated effect on I

17. Destabilizing Effect of Investment & Acceleration Theory I,K,y Kt2 ∆K Ig Kt1 yt In Ig Ir Ir,Ig t t1 t2

18. Taxes and investment Two of the most important taxes affecting investment: • Corporate income tax • Investment tax credit

19. Effect of Taxes on Investment • Corporate income tax is a tax on corporate profit. An increase in the tax may discourage business investment. • Investment tax credit is an incentive for businesses to invest. An increase in the tax credit would encourage business investment.

20. Corporate Income Tax: A tax on profits Impact on investment depends on definition of “profit.” • In our definition (rental price minus cost of capital), depreciation cost is measured using current price of capital, and the CIT would not affect investment • But, the legal definition uses the historical price of capital. • If PK rises over time, then the legal definition understates the true cost and overstates profit, so production firms could be taxed even if their true economic profit is zero. Thus, corporate income tax discourages investment.

21. The Investment Tax Credit (ITC) • The ITC reduces a firm’s taxes by a certain amount for each dollar it spends on capital. • Hence, the ITC effectively reduces PK which increases the profit rate and the incentive to invest.

22. Tobin’s q • numerator: the stock market value of the economy’s capital stock. • denominator: the actual cost to replace the capital goods that were purchased when the stock was issued. • If q > 1, firms buy more capital to raise the market value of their firms. • If q < 1, firms do not replace capital as it wears out.

23. Relation between q theory and neoclassical theory described above • The stock market value of capital depends on the current & expected future profits of capital. • If MPK > cost of capital, then profit rate is high, which drives up the stock market value of the firms, which implies a high value of q. • If MPK < cost of capital, then firms are incurring losses, so their stock market values fall, so q is low.

24. The stock market and GDP Reasons for a relationship between the stock market and GDP: 1. A wave of pessimism about future profitability of capital would: • cause stock prices to fall • cause Tobin’s q to fall • shift the investment function down • cause a negative aggregate demand shock

25. The stock market and GDP Reasons for a relationship between the stock market and GDP: 2. A fall in stock prices would: • reduce household wealth • shift the consumption function down • cause a negative aggregate demand shock

26. The stock market and GDP Reasons for a relationship between the stock market and GDP: 3. A fall in stock prices might reflect bad news about technological progress and long-run economic growth. This implies that aggregate supply and full-employment output will be expanding more slowly than people had expected.

27. The stock market and GDP Stock prices (left scale) Percent change from1 year earlier Percent change from 1 year earlier Real GDP (right scale)

28. Stock Market as an Economic Indicator

29. Alternative views of the stock market: The Efficient Markets Hypothesis • Efficient Markets Hypothesis (EMH):The market price of a company’s stock is the fully rational valuation of the company, given current information about the company’s business prospects. • Stock market is informationally efficient: each stock price reflects all available information about the stock. • Implies that stock prices should follow a random walk (be unpredictable), and should only change as new information arrives.

30. Alternative views of the stock market: Keynes’s “beauty contest” • Idea based on newspaper beauty contest in which a reader wins a prize if he/she picks the women most frequently selected by other readers as most beautiful. • Keynes proposed that stock prices reflect people’s views about what other people think will happen to stock prices; the best investors could outguess mass psychology. • Keynes believed stock prices reflect irrational waves of pessimism/optimism (“animal spirits”).

31. Alternative views of the stock market: EMH vs. Keynes’s beauty contest Both views persist. • There is evidence for the EMH and random-walk theory • Yet, some stock market movements do not seem to rationally reflect new information.

32. Financing constraints • Neoclassical theory assumes firms can obtain capital whenever doing so is profitable. • But some firms face financing constraints: limits on the amounts they can obtain(or otherwise raise in financial markets). • A recession reduces current profits. If future profits expected to be high, investment might be worthwhile. But if firm faces financing constraints and current profits are low, firm might be unable to obtain funds.

35. Increase in Housing Demand Relative price of housing, PH/P Relative price of housing, PH/P Supply Supply PH2/P PH1/P Demand Flow of residential investment, IH Stock of housing capital, KH Market for new homes Market for existing homes

37. Demand How residential investment responds to a fall in discount rates (a) The market for housing (b) The supply of new housing Supply Supply IH KH Stock of housing capital Flow of residential investment

38. U.S. Housing Prices and Housing Starts, 2000-2008 Housing prices (left scale) Housing starts (right scale)

39. Why Residential Investment is Unstable • Seasonality • Higher Bankruptcy • User Cost of Housing The Share of Depreciation is low and that of opportunity cost is high Housing is susceptible to Discount Rate Policy

40. Inventory investment Inventory investment is only about 1% of GDP. Yet, in the typical recession, more than half of the fall in spending is due to a fall in inventory investment.

41. The Importance of Inventories

42. Motives for holding inventories 1. production smoothing Sales fluctuate, but many firms find it cheaper to produce at a steady rate. • When sales < production, inventories rise. • When sales > production, inventories fall.

43. Motives for holding inventories 1. production smoothing 2. inventories as a factor of production Inventories allow some firms to operate more efficiently. • samples for retail sales purposes • spare parts for when machines break down

44. Motives for holding inventories 1. production smoothing 2. inventories as a factor of production 3. stock-out avoidance To prevent lost sales when demand is higher than expected.

45. Motives for holding inventories 1. production smoothing 2. inventories as a factor of production 3. stock-out avoidance 4. work in process Goods not yet completed are counted in inventory.

46. Accelerator Model of Inventories • Inventory investment is proportional to the level of output: I = ΔN = β ΔY ΔN = change in inventories ΔY = change in output β = factor of proportionality; β>0 • Inventory investment depends on whether the economy is speeding up or slowing down

47. Accelerator Model of Inventories • Inventory investment is proportional to the level of output: I = ΔN = β ΔY ΔN = change in inventories ΔY = change in output β = factor of proportionality; β>0 • Inventory investment depends on whether the economy is speeding up or slowing down

48. Evidence for the Accelerator Model

49. Inventories, the real discount rate, and credit conditions • Inventories and the real discount rate • The real discount rate is the opportunity cost of holding inventory (instead of, e.g., bonds) • Example: High interest rates in the 1980s motivated many firms to adopt just-in-time production, which is designed to reduce inventories. • Inventories and credit conditions • Many firms purchase inventories using credit. • Example: The credit crunch of 2008-09 helped cause a huge drop in inventory investment.. CHAPTER 18Investment

50. Summary • All types of investment depend negatively on the real discount rate. • Things that shift the investment function: • Technological improvements raise MPK and raise business fixed investment. • Increase in population raises demand for, price of housing and raises residential investment. • Economic policies (corporate income tax, investment tax credit) alter incentives to invest.